Tax implications for a prepaid forward contract on startup stock options - correct understanding?

This is a prepaid forward contract arrangement, and you're mostly right about the tax treatment, but there are some important nuances to understand. When you exercise your options, you'll still recognize ordinary income equal to the difference between the FMV ($2.50) and strike price ($1.25) per share, which would be subject to AMT. The prepaid forward contract itself is generally not a taxable event when you receive the upfront payment - it's essentially a loan against your future delivery obligation. However, when you deliver the shares in 3 years, you'll recognize capital gain/loss based on the difference between your tax basis in the shares (FMV at exercise) and the amount you received upfront. There could also be imputed interest considerations under the tax code. These arrangements are complex, and the IRS scrutinizes them carefully. I strongly recommend consulting with a tax professional who specializes in equity compensation before proceeding, as the tax consequences can vary based on the specific contract details.

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One critical thing nobody has mentioned yet is that the tax treatment depends on whether your options are ISOs or NSOs (sometimes called NQSOs). The AMT impact and holding period requirements are completely different! If they're ISOs and you exercise but don't immediately sell, you trigger AMT on the spread. If they're NSOs, you pay ordinary income tax on exercise regardless. Also, these prepaid forward arrangements often have hidden costs - the financial institution is essentially locking in a guaranteed return for themselves over those 3 years. Have you calculated what implied interest rate you're effectively paying?

Has anyone dealt with the tax reporting for these arrangements when they eventually complete? Do you get a 1099 or some other form from the institution? I'm curious about how the IRS tracks these deals.

One thing to be very careful about with these prepaid forward contracts is the "variable prepaid forward" requirement to avoid immediate taxation. The IRS looks closely at whether you've effectively eliminated both your upside potential and downside risk. If your contract guarantees delivery of exactly 100k shares regardless of the stock's future price, that could trigger constructive sale treatment under Section 1259. The contract needs to have some variability - like a collar structure where you deliver between 80k-120k shares depending on the final stock price. Also, make sure the investment company is reputable and properly regulated. I've seen situations where these arrangements fall apart because the counterparty had financial issues, leaving the option holder in a terrible position - they've already paid AMT on exercised options but can't recover their shares or the prepaid amount. Given the complexity and potential audit risk, I'd strongly recommend getting this reviewed by a tax attorney who specializes in derivatives and equity compensation, not just a regular CPA. The stakes are too high to get this wrong.

As someone who went through a similar situation last year, I want to emphasize the importance of understanding the timing of when you'll actually need to pay the AMT. Many people assume the prepaid amount will fully cover both the exercise cost and the AMT liability, but this isn't always the case. When I ran the numbers on my NSO exercise, the AMT hit was actually larger than I expected because of other factors in my tax situation that year. The prepaid forward helped, but I still needed additional cash to cover the full tax liability. Make sure you model out your complete tax picture for the exercise year, including any other income, deductions, or AMT preferences you might have. Also, consider the state tax implications if you're in a high-tax state - some states don't follow the federal rules exactly for these arrangements, which could create additional complexity. California, for example, has its own AMT rules that might treat your situation differently than the federal calculation. The three-year timeline also creates some interesting planning opportunities. If you expect to be in a lower tax bracket in the delivery year (maybe starting your own company with lower initial income), the capital gains treatment could be even more beneficial. Just something to factor into your overall decision-making process.

Before you proceed with this arrangement, I'd strongly recommend getting clarity on a few additional points that could significantly impact your decision: 1. **Exercise timeline pressure**: Since you mentioned being laid off, check your option agreement for the exact deadline to exercise. Most companies give 90 days post-termination, but some allow longer periods. This timeline constraint might be driving you toward this prepaid forward structure when other alternatives could be better. 2. **Alternative financing options**: Have you explored traditional option financing or exercise-and-sell arrangements? Some specialized lenders offer loans specifically for option exercises that might have better economic terms than giving up all future upside on 100k shares. 3. **Liquidity event timing**: Do you have any insight into when your company might go public or be acquired? If there's a potential liquidity event within the next 1-2 years, locking yourself into a 3-year forward contract could mean missing out on significant value creation. 4. **Contract termination provisions**: What happens if your company gets acquired before the 3-year delivery date? Some prepaid forwards have accelerated settlement clauses that might not be favorable to you. The tax treatment you described is generally correct for a properly structured variable prepaid forward, but as others have noted, the current contract terms you described (fixed 100k shares) sound more like a constructive sale. Given the complexity and your time pressure, consider getting a second opinion from another investment firm to compare terms and structures. The fact that this arrangement covers only 100k of your 120k options also means you'll need additional capital for the remaining 20k options anyway - make sure you're optimizing across your entire option portfolio, not just solving for the largest portion.